Credit Market Theories - I

Pavel Chakraborty
Development Economics, Lent 2023
Two important issues

 Is there a demand for credit in developing countries? Are firms credit

constrained?
 Why capital does not flow naturally to the poor?
Solow Model and Credit Markets

Background

• Solow (or augmented) model explains the differences between countries

• Solow model predicts: returns to factors and investment rates should be higher in
developing countries
• Banerjee and Duflo (2005) suggests that AVERAGE returns to physical (and human capital)
is not necessarily much higher (a lot of heterogeneity)…

… One possible explanation relates to assumption of competitive credit markets

Solow Model and Credit Markets

• Historically, many high-savings Asian economies grew rapidly

• One possible explanation: High investment rates encouraged adoption of new technology (e.g.,
Taiwan and South Korea)
• Important point: economists agree that while high rate of savings and investment is
important, but the efficiency of investment is just as important

Credit markets matter

Demand for Credit
Think of 3 broad categories:

1. Fixed Capital: Requirement of capital for expansion of existing capital/or new enterprise
• required for new start-ups or a substantial expansion of existing production line
• purchase and organization of fixed inputs, factories, production processes, machines, etc.
2. Working Capital: Due to lag between production and sales
• credit required for ongoing production activity
• occurs because of a substantial lag between the outlays required for normal production and sales
receipts
3. Consumption Credit: either due to production shock (i.e. poor crop) or expenditure
shock (catastrophic health payments etc.)
• typically demanded by the individuals who are strapped for cash
• educational/house/car loan, sudden downturn in production, sudden fall in the price of what they
sell or due to rise in their consumption needs caused by illness, death, festivities, etc.

3 is closely related to insurance – i.e. Ability to gain funds in the event of an unexpected
negative shock
Demand for Credit

• Fixed capital is of great importance in determining the overall growth of the economy
• working capital and consumption credit are fundamental to our understanding of how an economy
supports its poor and disadvantaged
• most prevalent in case of agriculture and small/micro enterprises (involved in manufacturing)
• In case of agriculture – seasonality of agricultural production and the low incomes of those
who live and work in the rural sector heightens the importance of working capital in
production
• Beginning of the crop cycle, a peasant needs a considerable need for working capital: money to
purchase seeds, fertilizers, pesticides, etc.
• Add seasonality to production activity, consumption credit is also important. An individual’s
harvest might fail, which causes immense temporary hardship that can only be alleviated through
loans
Demand for Credit in Developing Countries

Difficulty of Measuring Credit Constraints

• Do credit constraints in developing countries impede economic growth?

• Is capital effectively allocated, ?
• Credit constrained firms have a marginal product of capital that is higher than the market
interest rate (demand exceeds supply)
• Difficult to measure credit constraints. Surveys have generally been ineffective
• One approach regresses current investment on past profits – assumes that in cases where
investment is mostly dependent on cash flow, then credit must be constrained
Demand for Credit in Developing Countries

• McKenzie and Woodruff (2006, EDCC) estimate relationship between firm earnings and firm
capital:
• For firms with less than $200 of K, returns are as high as 15% per month, for firms between $200
and $500, 7%-10% , for firms between $500 and $1,000, 5%
• McKenzie, De Mel, and Woodruff (2008, QJE) randomly allocate small capital grants to
microenterprises in Sri Lanka and find high returns on capital are only at around 4%
• Banerjee and Duflo (2014, REStud) assess the importance of credit constraints for larger
firms in India
• finds a lot of heterogeneity
Demand for Credit in Developing Countries

Although very interesting, the above studies may be confined to small scales and not
necessarily have major aggregate consequences

• Results are not definitive

• Profits and investment are serially correlated and profits might be correlated with investment
for other reasons (e.g., managerial ability)
• Methods use exogenous short-term variations in cash flows
• Idea is that with perfect credit markets, no reason to believe that investment should depend on
past profits
Why capital does not flow naturally to the
poor countries?
Demand for credit remains unsatisfied

• According to the law of diminishing returns to capital, capital should naturally flow to
developing countries
• Lucas (1990) estimates the marginal returns to capital. He finds that borrowers in India
should be willing to pay 58 times more for capital as borrowers in the US
• Interest rates in developing countries between 40% and 150%

It means:
- Small investments should lead to high return
- Poor need small amount of capital, for small investment but high return
- Investors in rich countries should be happy to finance the poor in developing countries!
So, why does it not happen? Why does the demand remain unsatisfied?
How to explain that puzzle?

1. Why institutional lenders do not lend to the poor?

 Transaction Costs
 Limited Liability and Informational problems
 Limited Solutions: Collateral & Monitoring

2. Are informal lenders exploitative?

 Monopoly Power
 Default risk
 Multiplier model
Transaction Costs

Why does the demand remain unsatisfied?

Transaction costs
• Coordination cost: It is more costly to fund small amounts
• Administrative costs of handling small loans ranges from 15 to 40% (Braverman and Guash,
1989)
• Aleem (1990) marginal cost of lending estimated at 48.1%

But, still not enough to explain lack of credit given high returns to capital for some unfunded
projects
Transaction Costs

Smooth functioning of the credit market

• 2 features show that the functioning of the market to be problematic

• ‘inability to pay’ or ‘involuntary default’ – often difficult to monitor exactly what is being
done with a loan (a loan may be taken for productive reason, but may be used for other needs
that cannot be easily transformed into monetary repayment)
• ‘Voluntary or strategic default’ – a situation where the borrower can repay the loan, but simply
does not find in his interest to do so – this could be especially pertinent in contexts where the
legal system of loan enforcement is weak
• Examples of weak enforcement: (a) an effective international court of law does not exist; (b) in
developing countries, internal courts of law are often weak and absent
Transaction Costs

• Institutional/Formal Lenders: Govt. (or public-sector) banks, commercial banks, credit

bureaus, and so on. Often special banks are also being set up, as in Thailand, the
Philippines, and India, and in many countries, to cater especially to the needs of rural
population
• Main problem with formal lenders: often do not have personal knowledge regarding the
characteristics and activities of their clientele
• Cannot precisely monitor just how the loans are used
• Problem is not just production versus consumption, but there are more subtle reasons for a
systematic divergence between what the lenders want to do with the money and what borrowers
want
Rural Credit Markets

• Informal Lenders: When some forms of collateral by the economic agents are not
acceptable by the formal lenders, the presence of informal moneylenders rise
• For example, a large landowner who has land adjacent to that of a poor farmer may be
interested in the tiny plot as collateral; an employer of rural labour will accept labour as
collateral in case the labourer-borrower fails to repay.
• Therefore, when formal banks cannot effectively reach out to poor borrowers, it is no surprise to
find that informal moneylenders (landlord, shopkeeper, trade, etc.) do a much better job
• Another important reason: informal moneylender has much better information regarding the
activities and characteristics of the clientele
How to explain that puzzle?

1. Why institutional lenders do not lend to the poor?

 Transaction costs
 Informational problems
 Limited Solutions: Collateral & Monitoring

2. Are informal lenders exploitative?

 Monopoly Power
 Default risk
 Multiplier model
Rural Credit Markets

Institutional (formal) lenders typically lack information regarding the characteristics and
actions of their clients

 Can lead to problems of adverse selection (hidden characteristics) and moral hazard
(hidden behaviour)

More specifically one can think of information problems such as:

(1) production vs consumption – formal lenders may lack the information to observe
whether funds are used for productive purposes (which generate an income stream) or
consumption (which doesn’t)

(2) more subtle is the problem of limited liability

Informational Problems – Adverse Selection

• George Akerlof (QJE, 1970) won a Nobel Prize showing that information problems may
lead to a situation in which reputable lenders (or sellers) may leave the market to
disreputable players, resulting in a possible market collapse

• Basic Problem: No information about the riskiness of the borrowers’ projects (hidden
information)
• Add to our example: 50% borrowers have safe projects & 50% have risky projects
Informational Problems – Adverse Selection

• Adverse selection (and resulting negative expected profits) lead banks not to satisfy
demand = Credit Rationing
• Because repeated transactions relieve adverse selection, banks will often provide
preferences for regular customers
• More difficult for banks to know the type of borrowers in informal activities, too costly to
improve information
Informational Problems – Moral Hazard

• Unobservable actions or efforts are taken by borrowers after the loans has been disbursed
but before project returns are realized (hidden action)
• Basic Problems:
 Borrowers might exert too low effort in managing his business (ex-ante moral hazard)
 Borrowers may default strategically (ex-post moral hazard)
• Strategic default is a situation in which the borrower is able to fulfill his debt obligations
but decides not to. Varies inversely with the borrowers’ cost of default
• Might be expected that default would be more common where monitoring and contract
enforcement were weak (but low default rates in most developing countries, see Aleem
1990)
Limited liability

• In bankruptcy, an individual with limited liability is not responsible for paying a loan in
full
• Limited liability problem which leads to excessive risk taking
• Leads to a reluctance of banks to lend in situations when it faces information constraints:
borrowers actions (and charging higher interest rates actually makes default more likely)

Limited liability in context of asymmetric information:

• Adverse selection arises when a bank faces loan demand for both risky and safe projects,
and has no information to distinguish between them
• Moral hazard arises when the bank cannot observe the choices borrowers make between
safe and risky projects
Limited liability: An example
Choosing between a Safe and a Risky Project

Source: Roland (2014)

How to explain that puzzle?

1. Why institutional lenders do not lend to the poor?

 Transaction costs
 Limited Liability and Informational problems
 Limited Solutions: Collateral & Monitoring

2. Are informal lenders exploitative?

 Monopoly Power
 Default risk
 Multiplier model
Limited solutions: Monitoring

Monitoring
• Lender can also monitor use of loan. Monitoring increases borrowing costs, especially for
small loans
• If cost increases, so will interest rate Risk of adverse selection
• Both collateral (poor people don’t have collateral) and monitoring (contracts) are complex
problems. Credit market inefficiencies and transaction costs are high
Limited solution: Collateral

Collateral
• To mitigate moral hazard, lenders transfer risk to borrow by taking collateral against a
loan, which reduces limited liability
• Who can afford collateral? Rich borrowers. So banks discriminate against poor lenders

Is it that poor borrowers lack collateral?

Not necessarily but:
1. It may be costly for banks to sell (for instance, small quantities of land)
2. It may be only valuable to certain types of lenders. For instance, tenants may pledge
labour as collateral (valuable to local land owners but not to formal banks)
Summary

Institutional (formal) lenders rationally limit credit (credit rationing) and segment markets
(discriminate against the poor)

• Transaction costs: costly to lend small amount (exacerbated by monitoring cost to reduce
moral hazard)

• Limited Liability & Informational problems (limit in increasing interest rates and in the
use of collateral)

Do informal lenders follow the same logic or are informal lenders exploitative?
Characteristics of Rural Credit Markets

If rural markets were perfectly competitive and smoothly functioning, there would be a demand
curve for credit and a corresponding supply curve of credit, and the intersection of curves would
determine the volume of credit, and the intersection of curves would determine the volume of
‘credit’ and its equilibrium ‘price’ (interest rate) as well

 Informational constraints – fundamental feature that creates imperfections in credit markets.

Informational gap occurs at 2 level:
 (a) there is a lack of information regarding the use to which a loan will be put; and
 (b) there is a lack of information regarding the repayment decision

 Segmentation – a characteristic of the rural credit market is its tendency toward segmentation.
Many credit relationships are personalized and take time to build up. Typically, a rural money
moneylender serves a fixed clientele, whose members he lends to on a repeated basis.
Repeated lending, a phenomenon in which a moneylender lends funds to individuals to whom
he has lent before
Characteristics of Rural Credit Markets

 Interlinkage – existence of interlinked credit transactions. A majority of village

moneylenders do not pursue usury as their sole occupation. Most of them are wealthy
landlords, shopkeepers or traders dealing in the marketing of crops. Given a segmented
market, landlords tend to give credit mostly to their tenants or farm workers, whereas
traders favour lending to clients from whom they also purchase gain. Thus segmentation
often takes place along occupational lines, and the complementarity of some production
relationship facilitates the credit relationship

 Interest rate variation – Segmentation has a natural corollary: informal interest rates on
loans exhibit great variation, and the rates vary by geographical location, the source of
funds, and the characteristics of the borrower
Characteristics of Rural Credit Markets

 Rationing – Informal credit markets are characterized by widespread rationing; that is

upper limits on how much a borrower receives from a lender. By rationing, we mean that
at the going rate of interest, the borrower would like to borrow, but cannot. In this sense
credit rationing is a puzzle: if the borrower would like to borrow strictly more than what
he gets, there is some surplus that the moneylender can grab by simply raising the rate of
interest a wee bit more

 Exclusivity – Finally, many informal credit transactions are characterized by exclusive

dealings. Moneylenders typically dislike situations in which their borrowers are
borrowing from more than a single source. They insist that the borrower deal with them
exclusively; that is approach no other lender for supplementary loans
Role of informal markets

Key problem: informational constraints

Most notably the lender lacks information about: (a) actual use of funds (b) repayment
decision

Banerjee and Duflo (2007, JEP):

• No more than 6% of funds borrowed by the poor came from the formal sector in a survey of
13 developing countries
• Prevalence of high interest rates in the informal than formal markets
Credit Channels in Rice Production (Philippines)
Theories of Informal Credit Markets
Lender’s Monopoly

One explanation of the very high interest rates of interest that are sometimes observed is
that the lender has exclusive monopoly power over his clients and can therefore charge a
much higher price for loans than his opportunity cost

Two problems with this explanation:

• Empirical: certainly true that the credit market is segmented, but this is not necessarily a
justification for an assumption of complete monopoly. Pure monopoly is not out of the
question, but in today’s rural societies, we can at best assume that lenders have ‘local
monopoly’ with limits
• Theoretical: monopoly power in not necessarily an explanation of high interest rates, at least
of high explicit interest rates. From the point of view of efficient surplus generation, it is often
better to pick up moneylending profits in forms other than interest
Theories of Informal Credit Markets

Lender’s Risk Hypothesis

A more satisfactory explanation of high interest rates is provided by the lender’s risk
hypothesis. In its extreme form, this hypothesis maintain that lenders earn no return on their
money over and above their opportunity cost

There is a substantial risk of default in rural credit markets. Risk comes from many sources:
(a) risk of involuntary default: owing to sheer misfortune (crop failure, unemployment,
disease, death, etc.); and (b) possibility of voluntary or strategic default: the borrower
simply take the money and run or stubbornly refuse to pay up
Lender’s Risk Hypothesis
Consider a typical village money lender in this competitive market
Let be the probability of default

be the total amount of funds he lends out

opportunity cost of funds
interest rate charged in the informal sector

Since only a fraction of loans will be repaid, the money lender’s expected profit is:

( )
Lender’s Risk Hypothesis

‘zero-profit’ condition implies that this value must be zero in equilibrium. This implies:

When no default risk

informal interest rates = formal sector rates

When
the informal rate is higher to cover the risk of default
Theories of Informal Credit Markets

Default and Collateral

• Fear of default creates a tendency to ask for collateral, whenever this is possible
• Fundamentally, collateral are of 2 types:
• in which both lender and borrower value the collateral highly (it has the additional advantage
that it covers a lender against involuntary default);
• in which the borrower values the collateral highly, but the lender does not
Default and Collateral
Suppose a small farmer wants a loan of size (for a family emergency). He approaches the local
large landowner and the landowner asks him to pledge his land as a collateral for the loan. The
small farmer has a plot of land adjacent to the landowner and this is what he pledges.

interest rate charged on the loan

monetary value that the small farmer places on his land
monetary value that the big landowner attaches to the same plot

Since plot is adjacent, let’s assume

loss to the farmer from default (this is over and above the loss of his collateral)
Total loss to the borrower
Gain to the borrower He gets to keep the principal plus the interest
Default and Collateral
Thus, the borrower will prefer to return the loan if

Consider now the lender’s preferences. He will prefer his money back if
Combining both, we may conclude that loan repayment is in the interest of both parties only
if

lender’s valuation must not exceed borrower’s valuation by too much

lender’s valuation of the collateral that of the borrower

Suppose this does not hold, whenever borrower prefers to repay the loan,
the lender actually wants him not to do so
Theories of Informal Credit Markets
Informational Asymmetries and Credit Rationing

Borrowers can be of 2 types:

(a) high-risk (a landless labour in poor health)
(b) low-risk (e.g., a diligent farmer with a significant amount of land to cultivate; low risk of
crop failure and bankruptcy)

Risk can be correlated with observable characteristics (landholdings or access to irrigation) or

unobservable characteristics (farming skills in the face of a crisis, thriftiness, quality of his
land, etc.)

Informational asymmetries, which are based on the type of risk the borrower is associated with
gives rise to a situation where at prevailing rates some people who want to obtain loans are
unable to do so moneylenders can raise interest rates to dissuade the high-risk borrowers
but, the main question is: by how much?
Informational Asymmetries and Credit Rationing

• Consider a moneylender who faces two types of potential customers

• safe type
• risky type
• Each type of borrower needs a loan of size to invest in some project or activity
• Borrower can only repay if investment produces sufficient returns to cover the repayment
• 𝑅(𝑅 > 𝐿) → return of the safe borrower
• 𝑅 (𝑅 > 𝑅) → return for the risky borrower, but with probability 𝑝; with (1 − 𝑝), the return is 0
• Suppose that the lender has enough funds to lend to just one applicant and there are two loan
applications: 1 risky, 1 safe
• Main issues here are concerned with these two questions:
• Should the lender raise the interest rate until 1 borrower drops out?
• What is the highest interest rate, 𝑖 for which the safe borrower wants the loan?
Informational Asymmetries and Credit Rationing
• Let be the interest charged to the safe borrower and to the risky borrower

Safe borrower’s expected net return

Highest acceptable return for him is:

Risky borrower’s expected net return

Highest acceptable return for him is:

Since,
the risky borrower is willing to pay a higher rate of interest than the safe borrower and
this interest rate is independent of his probability of success,
Informational Asymmetries and Credit Rationing
What does the lender charge?

If the lender charges both borrowers will apply for the loan. Since, the lender can’t
tell them apart, he has to give the loan randomly to one of them

If the lender charges first borrower drops out and excess demand for loan
disappears, and the lender ends up only with the risky borrower

Suppose the lender charges . His expected profits are then given by

On the other hand, if he charges , he attracts each type of customer with probability .
His expected profits are given by
Informational Asymmetries and Credit Rationing

Under what condition will the lender be reluctant to charge the higher interest rate?

This will happen, when

Using the values of , and then and , we obtain,